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Tuesday, February 28, 2012

From Marcus Nunes we get this figure which helps shed some light on the recent upswing in the stock market. It shows that as inflationary expectations improve so does the stock market.

The easiest way to interpret this relationship is that when inflationary expectations rise, the market is effectively saying it expects higher aggregate demand in the future. Given nominal rigidities, the higher expected aggregate demand in turn means higher expected real growth. Ergo, higher stock prices. (For a more technical discussion on this relationship see David Glasner who first spotted this relationship.)

Note that Marcus Nunes shows in the figure how the Fed's various monetary easing programs have been tied to trend changes in inflation expectations and the stock market. Thus, the most recent developments might also be attributed to the Fed's new long-run interest rate forecasts which is not on the figure.

For me the big take away from this picture is that all this time the Fed has been playing with us. If the Fed's timid, piecemeal programs listed on the figure above can systematically affect the stock market, then just imagine what would happen if the Fed had gone nuclear and adopted a nominal GDP level target. The stock market would be way up, balance sheets would be stronger, the economic outlook would be vastly improved, and the economy would be back on path to full employment.

Update: Given my claims above, I was curious to see how close the TIPS-created expected inflation series tracked the nominal GDP forecasts provided in the quarterly Survey of Professional Forecasters. To do this, I transformed the 5-year expected inflation series into a quarterly average and plotted them against the forecasted growth of nominal GDP over the next four quarters. Here is what I got:

This indicates that my interpretation of the expected inflation series as an implicit forecast of expected future aggregate demand is appropriate, at least for now.

Monday, February 27, 2012

Paul Krugman argues that the primary problem facing Europe is a monetary one (my bold):

So what does ail Europe? The truth is that the story is mostly monetary. By introducing a single currency without the institutions needed to make that currency work, Europe effectively reinvented the defects of the gold standard — defects that played a major role in causing and perpetuating the Great Depression.

[...]

If the peripheral nations still had their own currencies, they could and would use devaluation to quickly restore competitiveness. But they don’t, which means that they are in for a long period of mass unemployment and slow, grinding deflation. Their debt crises are mainly a byproduct of this sad prospect, because depressed economies lead to budget deficits and deflation magnifies the burden of debt.

I agree that the Eurozone was a flawed currency union from the start. So yes, what ails Europe is a structural monetary problem. But the monetary problem goes deeper than that. There is also a cyclical monetary problem that is alluded to in the bold passage above. This cyclical dimension can be seen in the figure below:

This figure shows that ECB's failure to stabilize and restore nominal spending to expected levels--as proxied by the 1995-2006 trend--during the crisis as the real culprit behind the Eurozone crisis. This failure to act has been devastating because it means nominal incomes are far lower than were expected when borrowers took out loans fixed in nominal terms. European borrowers, both public and private, are therefore not able to pay back their debt and the result is a fiscal crisis.

The reduced ability for Europeans to payback debt also means that risk premiums on countries with lots of debt or ones perceived to have debt problems increases, further raising these country's debt burden with higher financing costs. The fiscal crisis gets bigger, and being easy to observe, gets wrongly credited as the cause of the Eurozone's problems. Consequently, the Eurozone crisis is prescribed with the fiscal solution of austerity. The real solution, then, requires the ECB to restore nominal incomes to their originally expected values. This is what ails Europe.

Friday, February 24, 2012

Money is what money does. There are two functions of money that define what is and what is not used as money: medium of exchange; and medium of account. That's it... We need to start worrying a lot more about how money works as a medium of exchange. We need to understand a lot better than we do how money works as a coordinating device in a decentralised economy. And we need to understand a lot better than we do how money can sometimes fail as a coordinating device. Because, outside a very simple economy, people can't barter their way back to full employment if the monetary exchange system fails.

We need to stop thinking of money as a store of wealth, just like all the others. And let's start by changing the textbook definition of money, by deleting that bit about money being a store of wealth.

I agree, but would add that we also need to start thinking about money at all levels of transactions. Most textbooks and many economists think of money assets at only the retail level (i.e. the M2 money supply). This crisis has taught us that institutional money assets--those assets like treasuries, commercial paper, and repos that facilitate transactions in the financial system--matter too. The bank run on the shadow banking system was a bank run using institutional money assets. If we really want to understand money and its implications for the economy we need to be thinking about these money assets too. Thanks to Gary Gorton, David Aldonfatto, and Stephen Williamson I have come to better appreciate this point. And thanks to this perspective I have come to see the demand for safe assets and budget deficits in a different light.

Just when you thought interest in nominal GDP (NGDP) might be waning there is more, including some discussions of it from central bank officials.

First, Mark Carney, Governor of the Bank of Canada delivered a speech where he discussed what would be a monetary policy for all seasons. He had some nice things to say about NGDP targeting, but ultimately comes out in favor of flexible inflation targeting as the top choice. The thing is, flexible inflation targeting is effectively like a NGDP target if conducted properly. Sweden is a good illustration of it. There are other examples, but the point is this: why not just be explicit about it? Doing so would not just formalize what is being done implicitly, but it would better anchor nominal expectations--especially if it were an level target--and thus reduce the chances of large collapses in aggregate nominal spending. Why not add more clarity? And why focus on a symptom (i.e. inflation) when one can focus on the cause directly (i.e. changes in aggregate demand)?

Now the above assume the flexible inflation target is executed flawlessly and ends up stabilizing aggregate demand. In practice, the discretion afforded a central bank under flexible inflation targeting makes it vulnerable to poor leadership and bad decisions. And it is likely bad decisions will arise under flexible inflation targeting because of supply shocks. In principle, such shocks should not be a problem for flexible inflation targeting, but in practice with political pressure and with real time data limitations they do create problems. Imagine, for example, there is a great productivity boom. All else equal, the natural interest rate would rise and disinflationary pressures would emerge. The central bank should ignore the disinflationary pressures and let the policy rate rise to the level of the natural interest rate to keep the economy at full employment. However, it might be tempting to leave the policy rate below the natural interest rate since the economy is humming from the productivity gains and inflation is low. It certainly would not be a popular move to raise interest rates. With a NGDP target such problems are ignored altogether. Simply focus on stabilizing the path of aggregate demand. Keep it simple.

Second, Renee Holtom of the Richmond Fed has a nice article examining the implications of the Fed tolerating higher inflation as a way to kick start a robust recovery. She discusses all the reasons for doing so, including a NGDP target.. The one thing missing is that she fails to mentions that the proper response to folks like Raghuram Rajan, who argues the Fed would do more harm to savers if it allowed higher inflation, is that the point of the temporarily higher inflation is to spark a recovery that would ultimately lead to higher real returns for savers. Interest rates are low because the economy is weak. Spark a robust recovery and watch real interest rates take off. This is a point that is missed by many, especially Bill Gross. (Also see Scott Sumner's response to Holton.)

Third, in what appears to be the latest convert to Market Monetarism, Jason Rave does a good review of NGDP targeting.

Monday, February 20, 2012

Christina Romer does the Five Books interview and one of her recommended reads is a famous article by Peter Temin and Barry Wigmore titled "The End of One Big Deflation." This is a great choice since it shows that even in a "balance sheet recession" facing a binding zero percent lower bound, monetary policy can still be very effective by managing expectations. The key is to radically shift expectations. Here is Romer discussing the implications of this article for today:

What we learned from the Temin and Wigmore paper is that one way out of a recession at the zero lower bound is by changing expectations. To do that, often what is needed is a very strong change in policy – something economists call a “regime shift”. The most effective way to shake an economy out of a terrible downturn when we’re at the zero lower bound is an aggressive change in policy that makes people wake up, say “this is a new day” and change their expectations. What the Fed has done since early 2009 is much more of an incremental change.

In other words, the Fed has failed to appropriately manage expectations and so we are stuck in a slump. And I am not convinced that it is now doing any better with its new long-run forecasts of the federal funds rate. So what in the current environment would rise to the level of a "regime shift"? What would change expectations enough to catalyze a broad-based recovery in aggregate demand? Here is Romer's answer:

I think that what the Fed needs instead is a regime shift. A number of economists have suggested that the Fed adopt a new framework for monetary policy, like targeting a path for nominal GDP. If the Fed adopted such a nominal GDP target, they would start in some normal year before the crisis and say nominal GDP should have grown at a steady rate since then. Compared with that baseline, nominal GDP is dramatically lower today. Pledging to get back to the pre-crisis path for nominal GDP would commit the Fed to much more aggressive policy – perhaps more quantitative easing and deliberate actions to talk down the dollar. Such a strong change in the policy framework could have a dramatic effect on expectations, and hence on the behavior of consumers and businesses.

Such a regime shift would require Bernanke to man up and have his own Volker moment, as previously noted by Romer. It would be a huge change and that is the point. A big shock to public expectations, one that would meaningfully change the expected path of future aggregate nominal spending, could be created by a public commitment to a nominal GDP level target. This is just the medicine the U.S. economy needs right now.

Thursday, February 16, 2012

I have made the case many times that the Fed is a monetary superpower. It controls the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Consequently, its monetary policy gets exported across much of the globe. The other two monetary powers, the ECB and the Bank of Japan, are therefore mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy gets exported to some degree to Japan and the Euro area as well. This understanding implies the Fed helped fuel excessive global liquidity in the early-to-mid 2000s, but now it is doing the opposite with its passive tightening of monetary policy.

This understanding also weaves nicely into the shortage of safe assets story. Back in the early-to-mid 2000s the Fed's loose monetary policy meant dollar-peggers had to buy up more dollars to maintain their pegs. These economies then used the dollars to buy up U.S. debt. This increased the demand for safe assets and further drove down yields. Fast forward to late 2008. The Fed fails to prevent the collapse of NGDP and never attempts to fully restore it to some reasonable pre-crisis path. This causes the destruction of many safe assets and thus further exacerbates the safe-asset problem. Now these developments are only the cyclical part of the safe asset problem--there was also a structural shift in demand for safe assets coming the emerging world--but it is an important part of the story.

I bring this up because Andrea Ferrero of the New York Fed has a new paper that makes a similar argument. He, however, uses more formal modeling than me and notes the implications for the current account deficits. He is careful not to say the Fed's monetary superpower status was the only factor, yet finds that it was quantitatively important. Here is an Ferrero:

[T]hese [pegging] countries import U.S. monetary policy so that low U.S. interest rates lead to low global interest rates. The quantitative analysis shows that foreign pegs, coupled with over-expansionary U.S. monetary policy, exert additional downward pressure on the real interest rate and impair a real depreciation of the dollar that would help rebalance the U.S. current account de cit. Taken together, the relaxation of borrowing constraints and low interest rates in the U.S. coupled with foreign pegs account for about two-thirds of the increase in real house prices and almost one-half of the deterioration of the current account during the first half of the 2000s. These quantitative findings complement the role of other factors in accounting for the correlation between the house price boom and the deterioration of the current account in the U.S. during the early 2000s.

As noted above, the flip side of this argument is that Fed is now being too tight for the global economy, at least passively.

Ramesh Ponnuru has a new article on Ron Paul's monetary economics. It is a great read throughout that highlights some of the problems with Ron Paul's views. Among other things, Ponnuru explains many of the well-known problems of the gold standard and its role in making the Great Depression so great. Here is an excerpt (my bold):

Representative Paul’s strategy for dealing with the theoretical and historical arguments against the gold standard in End the Fed is to ignore all of them. All he says is that problems arose in the 1930s because of the “misuse of the gold standard.” But note that the great advantage of the gold standard is supposed to be that governments cannot manipulate it. Concede that they can and the argument is half lost.

That is an important point. If the interwar gold standard did not work because France and United States were not playing by the rules of the game, why do we think countries would be any better behaved today? Would the U.S. political process really be able to tolerate the requirements of a gold standard? I do not see it happening. This is especially true if the gold standard covered an area that was not an optimal currency area. Look no further than the current Eurozone crisis or the UK leaving the European Monetary System in 1992. Both demonstrate how difficult it is to maintain a fixed exchange rate monetary system when internal economic concerns conflict with external ones.

P.S. Kurt Schuler probably will not be happy with this post of mine either.

P.PS. George Selgin proposes an innovative solution to some of the gold standard problems in his quasi-commodity standard.

Friday, February 10, 2012

David Andolfatto recently discussed an interesting speech by St. Louis Fed president James Bullard:

I think that Bullard makes a persuasive case that the amount of household wealth evaporated along with the crash in house prices should likely be viewed as a "permanent" (highly persistent) negative wealth shock. Standard theory (and common sense) suggests a corresponding permanent decline in consumer spending (with consumption growing along its original growth path). The implication is that the so-called "output gap" (the difference between actual and "trend" GDP) may be greatly overstated by conventional measures.

To some extent the CBO agrees with Bullard. They have adjusted their potential real GDP estimates below pre-crisis trend path values. Still, there remains a large output gap, one that Bullard finds questionable given the negative wealth shock. So how much is the output gap is overstated? And how do we know which measure of the output gap to trust? These are hard questions and I am not sure they are even the right ones to be asking. I believe a more constructive approach is to consider whether there still remains monetary problems that could be addressed by monetary policy.

To begin thinking about whether monetary problems remain, and doing so in light of Bullard's concens about a negative wealth shock, consider the figure below. It shows for the years 1952:Q1 - 2011:Q4 the percent change from a year ago of households net worth plotted against the change from a year a ago of households liquid asset share (i.e. currency, checking accounts, saving and time deposits, retail money market funds, and treasuries as a percent of total household assets). This liquid asset share can be interpreted as a measure of household money demand.

There is a strong negative relationship here that suggests positive household money demand shocks tend to pull down household net worth. And currently households are maintaining unusually high shares of liquid assets in their portfolios, indicating there has been series of positive money demand shocks:

In other words, some of the negative wealth shock mentioned by Bullard is probably tied to the elevated money demand by households. Another way of viewing this issue is that household have adjusted their portfolios toward highly liquid, safe assets. Is this a problem could the Fed could fix? Yes. Through proper expectations management the Fed could cause households to start rebalancing their portfolios toward more normal levels. Josh Hendrickson and I have a paper that provides systematic evidence on the link between household portfolio rebalancing and aggregate nominal spending. The Fed has influence here and armed with something like a nominal GDP level target it could do wonders in catalyzing massive portfolio rebalancing by households. (And no, bank lending is not necessary for the rebalancing of household portfolios and no, long-term inflation expectations would not become unmoored since this is a level target.)

Household's elevated demand for retail money assets, however, is only part of the current monetary problem. There is also an elevated demand by large institutional investors for transaction assets that facilitate exchange (commercial paper, treasuries, repos, large-time deposits, institutional money market funds, etc.). Unlike retail money assets, though, which have grown in response to the spike in retail money demand, the problem here is that the elevated demand for institutional money assets has occurred as their supply has fallen. This can be seen in the following figure that shows monetary divisia aggregates through M4. These measures include the retail money assets but also institutional money assests (i.e. M4 divisia = M2 assets plus commercial paper, treasuries, repos, large-time deposits, institutional money market funds weighted appropriately).

Since M2 has risen, the reason for the M4 divisia decline in the reduction of institutional money assets. As I have argued before, the failure of the Fed to restore nominal incomes to their pre-crisis expected path (even after accounting for the slightly higher levels during the housing boom) both reduced institutional money assets while increasing the demand for them. The Fed could breach this gap by adopting a nominal GDP level target that restored aggregate nominal income to a reasonable pre-crisis path. This should be the focus of James Bullard's efforts. Forget the output gap, start worrying about the aggregate nominal income gap.

P.S. Josh Hendrickson has a forthcoming paper where he shows that the Great Moderation can be traced to the Fed effectively targeting nominal income. The failure of the of the Fed to keep doing so in late 2008, early 2009 explains many of our economic problems today.

Tuesday, February 7, 2012

Could the Fed spark a robust recovery by raising its federal funds rate target? For Bill Gross the answer is yes. He believes a key reason holding back the recovery is that the Fed is engaged in a type of financial repression where financial intermediaries' net interest margins--the difference between their funding costs and lending interest rates--are being squeezed by the Fed's low interest rate policies. He sees the Fed driving down interest rates across the yield curve and thus removing the incentive for lending. If only it were that easy.

Thursday, February 2, 2012

An important problem facing the global economy is the shortage of safe assets, assets that facilitate transactions at both the retail and institutional level. There is both a long-term, structural dimension to this problem as well as a short-term, cyclical one. The structural dimension is that global economic growth over the past few decades has outpaced the capacity of the world economy to produce truly safe assets, a point first noted by Ricardo Cabellero. The cyclical dimension is that the shortage of safe assets was intensified by the Great Recession, a point stressed by Gary Gorton. I previously made the case that both the Fed and the ECB were an important part of the cyclical story by failing to restore nominal incomes to their expected, pre-crisis paths. In other words, since 2008 the Fed and the ECB passively tightened monetary policy which caused some of the safe assets to disappear while at the same time increasing the demand for them.

I still hold this view, but after reading some papers on safe assets and talking with Josh Hendrickson I have come up with a more general view to the cyclical dimension of the safe asset problem. It goes as follows.

Gorton, Lewellen, and Metrick (2012) show that safe assets have constituted a relative stable share of all assets since the 1950s. They also show, as does Bansal, Coleman, and Lundblad (2011), that public and private safe assets tend to act as substitutes in providing liquidity services. Given these findings, it stands to reason that when the central bank is doing its job and nominal GDP (NGDP) is growing at its appropriate trend, then there will be enough safe assets being privately provided. If, however, the central bank slips and NGDP falls below its expected path, then some of the privately produced safe assets disappear, creating a shortage of safe assets. The government steps in and creates safe assets that, if produced sufficiently, would restore NGDP back to its expected path. In other words, if monetary policy does not do its job then fiscal policy could substitute for it, but in a way not normally imagined. It would do so not by increasing aggregate demand via higher government spending, but by making up for the shortage of safe assets that facilitate transactions. All this requires is running a budget deficit which may or may not imply higher government spending (i.e. it could also come from tax cuts). Debates about Ricardian equivalence, crowding out, and other fiscal policy concerns become moot. What matters is if there are enough safe assets, and if not, whether fiscal policy can provide them in the absence of a NGDP-stabilizing monetary policy.

This understanding may serve as the basis for a paper, so I look forward to any feedback you can provide.